*1511 1. Petitioner during the taxable year was in the hands of a receiver but was not insolvent. The receivership had not been instituted by the corporation's creditors but by a dissatisfied stockholder. Petitioner had assets which considerably exceeded its liabilities and during the taxable year had a net income of $54,101.14 and paid to its principal creditor very substantial payments on its indebtedness. Held, that petitioner is not exempt from the undistributed profits surtax as an insolvent corporation in receivership, under the provisions of section 14(d)(2), Revenue Act of 1936.
2. Petitioner in the beginning of the taxable year had a deficit, but with its earnings in the taxable year that deficit was wiped out and at the end of the year it had an earned surplus. Held, that the applicable code of California, which prevented petitioner from declaring any dividend so long as it had a deficit, is not a contract restricting the payment of dividends within the meaning of section 26(c)(1), Revenue Act of 1936. Helvering v. Northwest Steel Rolling Mills, Inc.,311 U.S. 46">311 U.S. 46.
3. Petitioner, to secure its indebtedness to an insurance company which*1512 was its principal creditor, several years prior to the taxable year gave a mortgage on two farms which it owned, and as additional security it assigned certain oil royalties which it was to receive under the terms of an oil lease. These oil royalties were to be paid to petitioner and not to the creditor. Held, there is nothing shown in the assignments of these oil royalties as additional security which expressly restricted petitioner in the payment of dividends within the meaning of section 26(c)(1), Revenue Act of 1936.
*408 The Commissioner has determined a deficiency of $7,380.33 in petitioner's surtax liability for the year ended December 31, 1937. The Commissioner in his deficiency notice, in explanation of his determination of the deficiency, stated as follows:
No change is made in the net income as reported in the return filed for the taxable year, and the deficiency stated herein is due to the computation of the surtax on undistributed profits imposed by Section 14 of the Revenue Act of 1936, for which no computation was included in the*1513 return.
The contention made, in both the return and the protest, that the corporation was not liable in the taxable year for the surtax imposed by the said Section 14, is denied for the reason that the evidence presented fails to show that you came within the purview of the exemption granted by Section 14(d)(2).
In computing the surtax only the amount of $8,250.00 paid on relevant indebtedness is allowed as a credit for contracts restricting dividend payments, under the provisions of Section 26(c)(1) of the Revenue Act of 1936, for the reason that the information presented fails to substantiate that a greater credit is allowable.
*409 To this action of the Commissioner imposing a surtax upon the undistributed profits of petitioner for the year 1937, the petitioner has assigned error. That assignment of error has been denied by the Commissioner and this presents the only issue for our decision.
FINDINGS OF FACT.
The petitioner is a California corporation, with principal place of business in the city of Los Angeles in said state.
Prior to and during the taxable year the petitioner owned certain assets which are described in part only in our record. Specifically*1514 two parcels of farm lands are legally described in a mortgage dated November 12, 1929, which is in evidence. Certain other properties, namely, the Shell Oil lease, the Home Villa Tract (a subdivision), and the Asphalt Paving Co. lease are referred to by names only in the evidence. From the income producing standpoint the Shell Oil lease, which yielded more than 90 percent of all of petitioner's income during the taxable year, was the most valuable of all of these properties.
On November 12, 1929, the petitioner refinanced a loan owing by it to the Pacific Mutual Life Insurance Co., a corporation, hereinafter called the insurance company, by delivering to the latter two promissory notes, for $175,000 and $35,000, respectively, due five years after date and bearing interest at the rate of 6 percent per annum. To secure payment of these notes the petitioner executed in favor of the insurance company the mortgage hereinbefore mentioned covering its two parcels of farm lands described therein. In connection with the loan of $175,000 the petitioner assigned a lease in which the Shell Oil Co. was lessee as a further security for the payment of the note. In accordance with the terms*1515 of the agreement the Shell Oil Co. continued to pay all royalties to the petitioner. This practice was continued through the entire year 1937. There is no evidence in the record indicating that there was any contract in writing wherein the petitioner agreed not to pay any dividends during the period it was obligated under the $175,000 loan.
In addition to the mortgage and assignments so executed to secure payment of the said notes, a separate agreement was made respecting the $35,000 note to the effect that the petitioner would refrain from declaring any dividends upon its capital stock so long as said note remained unpaid. The Commissioner has allowed a credit in computing petitioner's undistributed profits tax for the amount paid by petitioner on this $35,000 note during the year 1937.
On July 16, 1935, William E. Ware was appointed receiver for the petitioner. The appointment of Ware as receiver arose out of an action by one J. Baldwin against Frederick Ringe, who was a stockholder of the petitioner. Baldwin had a judgment against Ringe in an amount approximating $200,000, which apparently could not be *410 satisfied. After considerable investigation Baldwin located*1516 a safe deposit box used by Ringe which contained some of the capital stock of the Artesian Water Co., the petitioner. The stock was acquired by Baldwin under a sheriff's sale and in due course application was made to have the stock thus acquired by Baldwin transferred to him on the corporate records. The corporate officers refused to transfer the stock to Baldwin, whereupon he petitioned the Superior Court for the appointment of a receiver, on the ground that the corporate officers were not functioning under the code, which action resulted in the appointment of Ware as receiver. The receivership proceeding was not brought, nor was it continued, by reason of the inability of the corporation to pay its debts. Petitioner had substantially no debts except the amounts which it owed to the Pacific Mutual Life Insurance Co. This latter company had no part in the appointment of the receiver, nor did it at any time press for the continuance of the receivership. The following is the order entered by the court upon the appointment of the receiver:
IT IS HEREBY ORDERED that until further order of this Court WILLIAM E. WARE, is named and appointed receiver of the ARTESIAN WATER COMPANY, *1517 a corporation.
That the receiver has, under the control of this court, power to bring and defend actions in his own name as receiver; to take, manage, operate and keep possession of the property, both real and personal, and each and all of it; to receive rents; collect debts; to compound for and compromise the same; and, subject to order of Court, to make transfers. The receiver is authorized to take possession of all books, records, correspondence and accounts of the said ARTESIAN WATER COMPANY.
Said receiver, subject to the Order of this court, shall have the full power and authority to operate the business of the ARTESIAN WATER COMPANY in each and all of its departments, and in its entirety.
The receiver took over petitioner's properties on the above date and immediately began negotiations with the insurance company for an extension or renewal of the loans above described. While these negotiations were pending, a conservator was appointed for the insurance company by the State Insurance Commissioner of California. There is nothing in the record to show that the appointment of the conservator by the insurance commissioner had anything to do with the indebtedness of petitioner. *1518 After the conservator for the insurance company took charge, he disapproved said loans to petitioner on account of an interlocking relationship between the two corporations and refused any further extension of time for their payment. The receiver then attempted to refinance the loans through brokers but was unsuccessful owing to questions raised over his legal authority to pledge the intrusted assets.
In the situation, the insurance company consented to "informally" allow the petitioner until March 2, 1937, to refinance the loans, *411 conditioned upon certain payments being made during the ensuing period. The petitioner paid $25,000 upon the notes during the year 1936 and made additional payments during 1937 which reduced the joint balance on the notes to $100,250. The petitioner owed no debts, other than current obligations, which were paid when due, at any time here shown, except its said debts to the insurance company, and was at all times here material a solvent corporation.
OPINION.
BLACK: The petitioner in its return for the taxable year reported gross income of $171,493.42, from which it claimed deductions amounting to $119,805.17, leaving a taxable net*1519 income of $54,101.14, upon which it paid the normal income tax for the year.
The petitioner paid no surtax upon its undistributed profits for the year but in its return claimed an exemption from that obligation. It stated its claim for exemption as follows:
Exemption from undistributed profits surtax is claimed on the following grounds: Attention is respectfully directed to Section 14 of the Revenue Act of 1936, part (d)(2) of which reads:
(d) Exempt from surtax. The following corporations shall not be subject to the surtax imposed by this Section:
(2) Domestic corporations which for any portion of the taxable year are in bankruptcy under the laws of the United States, or are insolvent and in receivership in any Court of the United States, or of any State, Territory, or the District of Columbia.
The word "insolvent" was apparently used in its dual sense by Congress. The Senate Finance Committee Report on the Revenue Bill of 1936 of June 1, 1936, on page 15, in discussing Section 14(d)(2), said:
The Finance Committee Bill also avoids the possibility of tax avoidance by collusive receiverships by limiting the provision to cases in which the corporation is in bankruptcy*1520 under the Federal bankruptcy laws, and to cases in which it is insolvent, i.e., its liabilities are in excess of its assets or it is unable to pay the claims of creditors as they mature - and in receivership in Federal of State Courts.
The taxpayer was certainly unable to pay the claims of its creditors as they matured. That is, it was unable to pay them in the usual course of business out of quick assets without selling its capital assets. 32 Corpus Juris 806 states that the word "insolvency" has two meanings:
In its general and popular meaning, the term denotes the state of one whose entire property and assets, when converted into money without unreasonable haste or sacrifice, are insufficient to pay his debts: But it is frequently used in the more restricted sense to express the inability of a person to pay his debts as they become due in the ordinary course of business.
Creditors claims, referred to above, which the corporation was unable to pay at maturity, consist of balance due the Pacific Mutual Life Insurance Company on account of Money borrowed on November 12, 1929, and represented by two notes, one for $35,000 and one for $175,000. The note for $35,000 carried*1521 with it a *412 specific agreement prohibiting the payment of dividends until said note was paid. During 1936 the sum of $26,750 was paid on this note leaving a balance of $8,250 which balance was paid during 1937, whereupon the note and collateral agreement were cancelled.
Similarly, during 1937 payments totaling $74,750 were made on the note for $175,000, making a grand total of payments made of $83,000.
The corporation owns subdivision land and oil producing property. The oil land is under lease to Shell Oil Company. The corporation secured its note to the Pacific Mutual Life Insurance Company by a mortgage on its properties, and gave as collateral security an assignment of the oil lease "together with all rents due, or to become due thereunder." The mortgagee notified Shell Oil Co. of the pledge of the lease and rents and instructed Shell Oil Co. to continue to pay the rents and royalties due under the lease to the corporation until further notice. The note and mortgage became due November 30, 1934, and is still past due. It has not been extended or renewed, and will outlaw November 30, 1938.
The corporation has never been in a position to pay off the mortgage*1522 out of current assets. From the foregoing, it is apparent, therefore, the corporation was insolvent and in receivership during the taxable year 1937, and is exempt from the surtax under Section 14.
The respondent in his audit disallowed petitioner's claim for exemption as an insolvent corporation, but, in recognition of its agreement not to declare dividends so long as the $35,000 note remained unpaid, allowed it a credit from the adjusted base in amount of $8,250, under authority of section 26(c)(1) of the Revenue Act of 1936 1
*1523 Petitioner, in its brief, states that the points which it relies upon are as follows:
1. The petitioner was in receivership and insolvent in the taxable year.
2. The California codes prohibited the declaration of dividends by the petitioner during the taxable year.
We shall take these points up in their order. As to point 1, it is clear that petitioner was in receivership, but it is also equally clear that this receivership was not occasioned by any insolvency of petitioner. It was due to an altogether different cause. Petitioner concedes that the receivership was not instituted by its creditor, the insurance company, nor was it prolonged by any insistence on the part of the insurance company. Petitioner does contend, however, that in the taxable year 1937 it was insolvent within the meaning of the applicable statute, and that, when the two conditions exist simultaneously, namely, insolvency and receivership, then the exemption provided by section 14(d)(2) applies. Petitioner, in support of its *413 contention that it was insolvent during the taxable year within the meaning of the act, quotes from *1524 :
Insolvency, in the sense of the Bankrupt Act, means that the party whose business affairs are in question is unable to pay his debts as they become due, in the ordinary course of his daily transactions; and a creditor may be said to have reasonable cause to believe his debtor to be insolvent when such a state of facts is brought to his notice respecting the affairs and pecuniary condition of his debtor as would lead a prudent man to the conclusion that the debtor is unable to meet his obligations as they mature, in the ordinary course of his business. ; . * * *
That the word "insolvent" as used in section 14(d)(2) was intended by Congress to carry the meaning used in the above language by the Supreme Court, petitioner contends is evidenced by Senate Finance Committee Report of June 1, 1936, on the Revenue Bill of 1936, where on page 15, in discussing section 14(d)(2), it is said:
The Finance Committee bill also avoids the possibility of tax avoidance by collusive Receiverships by limiting the provision*1525 to cases in which the corporation is in bankruptcy under the Federal bankruptcy laws, and to cases in which it is insolvent, i.e., its liabilities are in excess of its assets or it is unable to pay the claims of creditors as they mature - and in receivership in Federal or State Courts.
We accept as correct the contention which petitioner makes as to the meaning of the word "insolvent" as used in section 14(d)(2). We do not think, however, that the evidence shows that petitioner was "insolvent" within the meaning of the act and the foregoing definition at any time during the taxable year. In a balance sheet attached to its income tax return for the taxable year, its total assets are listed at a value of $1,162,789.84; its total liabilities, exclusive of capital stock and surplus, are listed at $144,255.21. It had net income in 1937 of $54,101.14.
While it did not finish paying all of its indebtedness to the insurance company in 1937, it paid $83,000 of it in that year and, as has already been stated, this creditor had nothing whatever to do with instituting the receivership and took no part in prolonging it. Under these circumstances we can not hold that petitioner was an*1526 insolvent corporation in receivership during the taxable year. It was not exempt under section 14(d)(2). On this point we sustain respondent.
As to point 2, raised in petitioner's brief, it is equally clear that the respondent must prevail. The question of whether or not state laws and/or charter provisions of a corporation create contractual relations recognizable in determining Federal income tax questions has been the subject of diverse decisions in different courts, notably in , where the Circuit Court of Appeals for the Ninth Circuit sustained *414 the position herein contended for by the petitioner; and in , wherein the Circuit Court of Appeals for the Eighth Circuit held to the opposite view. To settle this conflict in Circuit Court opinions, the Supreme Court granted certiorari in both cases, and in rendering its decisions sustained the Eighth Circuit Court's views in *1527 , and reversed the Ninth Circuit Court's decision in . Following the Supreme Court's decision in these two cases, we sustain respondent as to point 2.
We have disposed of the two points raised by petitioner in its original brief. The petitioner, in its reply brief, has raised a third point which in substance is this: Petitioner had assigned prior to May 1, 1936, as additional security for the payment of its $175,000 note due the insurance company, the oil royalties which it was to receive from the Shell Oil Co., and while this assignment did not expressly limit petitioner in the payment of dividends so long as any of the $175,000 note remained unpaid, nevertheless there was an implied restriction on the payment of dividends imposed by the agreement, and petitioner is entitled thereby to a credit under section 26(c)(1), supra.
There is nothing to show that the assignment of the Shell Co. oil royalties by petitioner to its creditor, the Pacific Mutual Insurance Co., as further security for the payment of its $175,000 note, in any*1528 manner expressly restricted petitioner in the payment of dividends. This assignment is not in evidence and we do not know what written provisions it contained, but the witness who testified in regard to it did not say that the assignment dealt "expressly with the payment of dividends." Petitioner does not so contend in its brief. It simply contends that because petitioner had assigned these oil royalties to its creditor, as additional security for the payment of its notes, it was by necessary implication prohibited from the payment of any dividends during the effective period of the assignment. We think this contention must be denied. Cf. .
Petitioner does not make any claim that it is entitled to a credit under the provisions of section 26(c)(2). On account, however, of the close connection between paragraphs (1) and (2) of section 26(c) of the Revenue Act of 1936, perhaps we should say a word as to the applicability of section 26(c)(2) to the facts of the instant case. We have considered the evidence carefully and we find no contract in evidence which would seem to fall within the provisions of section 26(c)(2).
*1529 *415 Our decision in , which was under section 26(c)(2), is not applicable to the facts in the instant case. In that case the taxpayer, to secure the loans with which to purchase certain oil leases and oil royalties, executed and delivered to the bank from which it was borrowing the money appropriate deeds of trust and also by separate instruments in writing assigned its interests in the properties to the bank in trust and authorized the bank to receive and collect all sums of money derived from the properties and to apply same on its indebtedness to the bank. Under those circumstances, we held that the taxpayer in computing its adjusted net income was entitled to a credit under section 26(c)(2) of the amount paid on its indebtedness during the taxable year in compliance with the contract.
In the instant case, there was no requirement that the oil royalties received from the Shell Co. should be paid to petitioner's creditor the insurance company, as there was in *1530 On the contrary, the oil royalties were to be paid to petitioner and were in fact paid to it. The insurance company had a mortgage on these oil royalty receipts, it is true, and it is undoubtedly true that a considerable portion of them was used as payments on petitioner's indebtedness to the insurance company, but it seems to us that this falls short of meeting the requirements of section 26(c)(2). Cf. .
For reasons above stated we think the facts in the instant case are distinguishable from those which were present in
Dicision will be entered for respondent.
Footnotes
1. SEC. 26. CREDITS OF CORPORATIONS.
* * * * * * * * *
(c) CONTRACTS RESTRICTING PAYMENT OF DIVIDENDS. -
(1) PROHIBITION ON PAYMENT OF DIVIDENDS. - An amount equal to the excess of the adjusted net income over the aggregate of the amounts which can be distributed within the taxable year as dividends without violating a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the payment of dividends. If a corporation would be entitled to a credit under this paragraph because of a contract provision and also to one or more credits because of other contract provisions, only the largest of such credits shall be allowed, and for such purpose if two or more credits are equal in amount only one shall be taken into account.↩